The Economy: The Makings Of A Perfect Storm? genre: Econ-Recon & Polispeak & Six Degrees of Speculation
There are more signs that the wheels may be about to fall off the economy and the Federal Reserve seems a bit nervous about how to best insure that doesn't happen. The prevailing question at the moment centers on whether to continue the long string of rate hikes in order to keep inflation in check or to ease off in order to keep the economy rolling forward. Regardless, it now appears that consumer confidence has reached a level where spending is being voluntarily restrained in anticipation of leaner economic times. Bloomberg has two articles discussing the economy here and here.
Aug. 29 (Bloomberg) -- U.S. consumer confidence fell to a nine-month low in August as higher gasoline prices raised fears of inflation and a slowing housing market rattled Americans, a private survey showed.
Americans are restraining their spending, which makes up 70 percent of the economy, as gasoline prices are kept aloft by violence in the Middle East and a slowdown in the housing market makes them feel less affluent.
"The housing slowdown is an increasing drag'' on growth, said Zoltan Pozsar, an economist at Moody's Economy.com in West Chester, Pennsylvania. “That consumer and business confidence hold up as housing slows is crucial for the expansion.''
Frankly, one needn't be an economist to realize that if the housing market continues to slow, consumer confidence is going to weaken. Further, there are indications in a number of regions that housing prices may actually be dropping...a situation that will not only slow consumer confidence; it may well lead to a surge in foreclosures and bankruptcies and set into motion a scandal similar to the Savings & Loan debacle witnessed during the late 1980's.
"When you have a very visible strain in the economy like housing at present, something that probably won't break but just might, the Fed gives more weight to the potential for exponential losses,'' said Lou Crandall, chief economist at Wrightson ICAP LLC in Jersey City, New Jersey. "A policy shock would be more costly than usual at present.''
Minutes released today of the Federal Open Market Committee's Aug. 8 meeting, where interest rates were kept steady for the first time in two years, will likely show how worried policy makers are about a property downturn versus the dangers of accelerating inflation.
Unfortunately, it may be a case of over optimism to presume that the Federal Reserve's monetary policy can fully manage the factors that drive the U.S. economy...a belief that gained credence during the Greenspan years...a period of relative stability. Economic problems can easily spiral out of control as it is virtually impossible to isolate the influence of one economic segment from the remaining segments. Further, housing may well be the single most influential segment...one capable of triggering exponential ramifications.
Here's a plausible equation. If one assumes that the backlog of unsold homes continues to expand, there will be pressure to reduce home prices as those homeowners in financial difficulty are forced to cut their losses. Once that process begins, there is a potential for a dramatic drop in home values. As that happens, more and more homeowners...who have been allowed to borrow up to 125% of the value of their homes or have adjustable rate mortgages or interest only mortgages that convert to interest and principle mortgages within a specified period of time...find themselves in untenable situations.
While I can't provide hard data, it seems anecdotally accurate to conclude that the prevalence of short term mortgage products...loans that aren't fixed for a full 25 to 30 year period...makes more and more homeowners vulnerable to fluctuations within the economy and the housing market. Large numbers of homeowners have grown comfortable with refinancing to new mortgage products every few years. They have come to assume that there will be acceptable and favorable mortgage products available each time they need to refinance.
Unfortunately, as soon as the housing market begins to demonstrate instability...in the form of rising inventories, reduced construction, declining prices, or a higher incidence of foreclosures, the available products become much more conservative as well as longer term...a move necessitated by the inability to predict consumer success in the short term...and therefore a stable and successful lending portfolio for lending entities.
As homeowners realize that they may be unable to obtain favorable mortgage terms, those who conclude they won't be able to sustain the trend begin to look at selling their homes in order to relocate to lower priced housing. They immediately exert further downward pressure on the housing market as it becomes a race to get homes sold in anticipation of the trend...and that will undoubtedly lead to further reductions in home prices and therefore values.
Once housing prices begin to fall, the condominium industry is placed in danger. That happens because a greater percentage of condominiums aren't owner occupied as they were frequently first homes for many buyers who have ridden the housing boom into larger homes...often renting out their condos in a market of rising rental rates...able to cover the mortgage costs by virtue of the rent received. Additionally, many of these owners have refinanced their condominiums in order to pull out available equity in order to fund the purchase of larger, more expensive homes or to simply use the equity to purchase expendable products like automobiles, furniture, and other discretionary items.
As housing prices fall, condo values drop even faster as does the rent one can charge. Frequently, homeowners will attempt to unload rental properties first which then begins to impact apartment rental rates. As condo rental prices drop, apartments are forced to compete and the downward rental rate pressure is increased.
Clearly, one can see the domino effect that takes place once the housing market stalls. One must immediately examine construction activity once housing begins to decline. Obviously, if housing starts decline, jobs will be lost and unemployment will increase. Troubling as that may be, it gets worse. Frequently in a housing boom, the final push is to build more condominiums and apartments in order to provide lower priced housing to those who may be entering the market for the first time. Unfortunately, these projects are often funded and built upon the basis of pro-forma rents that won't be sustained in a housing slowdown.
As home prices decline, so do rental prices...creating circumstances whereby new condo and apartment properties cannot meet their debt structure which was based upon optimistic rental rates. They are also forced to compete with individual home rental rates as more and more homes hit the rental market at lower and lower rates.
The end result is often disastrous for lenders. Not only are there growing defaults on individual mortgages, they frequently see failures on large project loans (apartments and condominium projects). Lenders become increasingly cautious and money becomes more difficult to borrow. That practice limits small business lending and venture capital which now begins to impact the larger economy and the job industry.
Given that small business growth is largely responsible for job growth, a reduction in small business lending will frequently lead to expanding unemployment rates. Fewer jobs tends to put more homeowners out of work which only further accelerates downward pressure on housing prices as unemployed homeowners are forced to dump homes at lower prices in order to avoid foreclosures or bankruptcies. In essence, the repetitive downward spiral is self perpetuating until such time as the bottom is reached and the recovery cycle begins anew.
Fed forecasts presented to Congress last month predicted that inflation will hover around 2 percent to 2.25 percent next year -- a level that's higher than what some policy makers, including Chairman Ben S. Bernanke, have said is desirable. Bernanke added that inflation will probably recede in 2008.
Bernanke, 52, told Congress last month that rate changes take some time to work their way through the economy and that a housing downturn posed a risk to growth. He said in March 2005 that his comfort zone for inflation excluding food and energy was 1 percent to 2 percent, a range he hasn't disavowed since becoming Fed chairman this year.
"I am increasingly getting the feeling that is on the low side,'' said Richard Berner, chief U.S. economist at Morgan Stanley in New York. "The Fed may implicitly be choosing a slightly higher inflation objective than previously thought.''
It now takes a bigger increase in unemployment to bring inflation down by one percentage point, an equation economists refer to as the sacrifice ratio. A prolonged slump in housing may also have a large impact on household spending decisions; economists at Merrill Lynch & Co. estimate housing contributed 2 percentage points to growth, or about 60 percent, over the last three years.
"There is no reason to hammer the economy to bring inflation down another half point,'' said James Glassman, senior economist at JPMorgan Securities Inc. in New York.
The strategy of letting inflation drift slowly lower has its own risks, economists note. The economic pain to lower inflation may be even higher.
It is clear that the economy sits more squarely on a tipping point than it has for some five years. One of the problems with economic policy is the inability to calculate the intangible aspects of that policy...such as the impact it may have upon consumer confidence and spending. The economic data we frequently see cited is not dissimilar to political polling information. It offers a snapshot of sentiment but it isn't necessarily a predictor of future sentiment or actions. Numerous other factors may influence consumer sentiment...a growing reality in an increasingly unstable environment filled with the uncertainty of the Iraq war, Middle East turmoil, and the fear of terrorism.
Americans' expectations for the inflation rate 12 months from now rose to 5.5 percent in August from 5.1 percent in July. It reached a high this year of 5.6 percent in May, the Conference Board's figures showed.
Consumers were less optimistic about the labor market six months from now, suggesting consumer spending may sag further after slowing in the second quarter.
The share of people expecting better employment opportunities in the next six months fell to 14 percent, from 14.3 percent. The proportion of people surveyed who expect their incomes to rise was 17.7 percent after 18.3 percent.
Economists watch confidence gauges for clues to the strength of consumer spending. Even so, spending and confidence haven't been closely correlated this year, said Lynn Reaser, Boston-based chief economist at the Investment Strategy Group at Bank of America.
In the end, responsibility for economic conditions must also be shared by political leaders. To the extent that conflicts around the world and their associated uncertainty shapes consumer confidence, those in positions of power must be mindful of the ramifications of their decisions and actions. One would be hard pressed to identify a recent historical example of such tenuous circumstances. That alone should be instructive to those currently in power and should they fail to heed the emerging warning signals we may well enter a position of economic instability that matches the political instability. Ironically, one year after Katrina, we may well be witnessing the makings of a perfect storm.
Daniel DiRito | August 29, 2006 | 8:44 AM
Comments
1 On August 30, 2006 at 6:35 PM, chimneyswift wrote —
Good post. A bit labored drawing out the domino theory, though.
What I'm seeing in your critique is something that could really be butressed and perhaps abbreviated by referring to James Howard Kunstler.
As for "those currently in power" (as if a change in political office holders makes a difference at Chase Manhattan, etc.), why should they worry? It is no great concern to the truly wealthy when the economy goes all queasy. Quite to the contrary, it makes consolidating economic power that much easier. This is especially true in the age of globalization.
Otherwise, good work. I'll be coming back.
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